Tuesday, February 2, 2016

Olivier Blanchard/Joseph Gagnon: "Are US Stocks Overvalued?"

The old rule of thumb was the market's P/E and the economy's inflation rate should sum to 20 or less for equities to be fairly valued. We'll have more on the caveats later this week.
That said, the problem for traders or others with a less than a semi-decadal timeframe is that these valuation models don't really matter, that crowd psychology is what sets the price in the short to medium term.

From the Peterson Institute's RealTime Economic Issues Watch:

US stock prices rose for seven years in a row through late last year.
During that time, the US economy repeatedly underperformed
expectations. Popular indicators of stock valuation are above historical
norms, even after the declines of the past few weeks. It is therefore
no surprise to hear some analysts say stocks are overvalued and we are
due for a substantial adjustment. (Somewhat ironically: One of the
websites that give (reliable) data on current and past earnings, stock
prices, and interest rates, has an ad banner that reads: “Dow to drop
80% in 2016.”)

Are stocks obviously overvalued? The answer is no, and the reason is
straightforward. While growth has indeed been weaker than forecast, the
rate of return on bonds has also been revised downwards. And what
matters for the valuation of stocks is the relation between future
growth and future interest rates. Put another way, the equity premium,
the difference between the expected rate of return on stocks and the
expected rate of return on bonds, has if anything increased relative to
where it was before the crisis.

Let’s start with what fuels the fears of some analysts. Perhaps the
most widely used gauge of stock valuation is the price-earnings (P/E)
ratio, the ratio of a stock’s price to the annual corporate earnings
associated with that stock. Figure 1 displays two measures of the
average P/E ratio for the firms in the S&P 500 composite equity
index. The dotted line is the standard P/E ratio based on reported
earnings over the previous four quarters. Because of the unprecedented
collapse in earnings during the Great Recession, this P/E measure soared
to more than 100 in 2009, literally off the chart. The standard P/E
measure reached nearly 22 late last year and is currently around 20, a
bit higher than its 60-year average of 19.

A popular alternative measure proposed by Robert Shiller of Yale
University uses a 10-year average of past earnings (adjusted for
inflation) in order to smooth out temporary fluctuations (the solid line
in figure 1). The Shiller P/E measure eliminates the massive spike in
2009 and allows the fall in stock prices that year to show through.
Although the two P/E measures were often close to each other in the
past, the Shiller measure has been consistently higher than the standard
measure since 2010.1
The Shiller P/E ratio reached 26 late last year and is currently around
24, compared with a 60-year average of 20. This elevated Shiller P/E
measure is commonly cited as an indicator that stocks may be overpriced,
including by Shiller himself.

As figure 1 shows, the deviations of the P/E from its historical average
are in fact quite modest. But suppose that we see them as significant,
that we believe they indicate the expected return on stocks is unusually
low relative to history. Is it low with respect to the expected return
on other assets? A central aspect of the crisis has been the decrease in
the interest rate on bonds, short and long. According to the yield
curve, interest rates are expected to remain quite low for the
foreseeable future. The expected return on stocks may be lower than it
used to be, but so is the expected return on bonds....MORE